Small Business Tax Policy

Avoid These S-Corp Pitfalls

S-Corp business structure can be very advantageous, however there are several important negative characteristics that must also be considered.

Having your business structured as an S-Corp can have several advantages over a traditional partnership. However, making the switch isn’t always simple and there are several pitfalls. This article will detail the common mistakes S-Corp owners make that could cause them legal and tax headaches.

Advantages of an S-Corp

There are four major advantages of choosing an S-Corp.

Limited Liability

An S-Corporation shares several qualities with a traditional corporation, the main similarity being limited liability protection. Forming an S-Corp protects the individual owners from being personally liable from business creditors and litigation.

Single Taxation

Unlike C-Corporations, S-Corporations only get taxed at the individual level. Forming an S-Corp gives owners all the benefits of having a corporation without the drawbacks of double taxation. This is especially helpful for businesses that distribute most of its income to shareholders.

Reduce Self Employment Taxes

An S-Corp allows owners that are actively involved in the business to take a salary to reduce self employment taxes. Since only the salary will be subject to self employment taxes, active participants in the business can segregate their salary from their ownership profits. Compare this with an active participant in a partnership who would have 100% of their profit subject to self employment taxes.

Ownership Easily Transferred

Ownership in an S-Corp can be easily transferred without impacting the ownership of others within this business. Shares in an S-Corp can be sold from one owner to another owner, or from one owner to an outside party with ease. Additionally, an S-Corporation can be converted into a C-Corporation quite easily compared to most business entities.

S-Corp Pitfalls

Although there are several advantages of an S-Corp there are also four major pitfalls to S-Corp ownership:

Strict Requirements For Shareholders

Not everyone can have ownership in an S-Corp and there are several restrictions.

  • There cannot be more than 100 shareholders.
  • The S-Corp cannot issue any preferred stock.
  • Only individuals (not trust, estates, or certain tax exempt entities) can have ownership in an S-Corp.
  • Non-resident aliens can’t have ownership interest in an S-Corporation.

Can’t Have Uneven Allocation of Profit and Loss

One of the major drawbacks of S-Corp ownership is the rigid allocation of profits and losses. Profit and losses in an S-Corporation must be shared based on ownership percentage. However, in several industries profits and losses are shared based on other factors besides ownership interest. This pitfall can be avoided by paying salaries or bonuses based on how active some owners are in the business.

More Paperwork and Corporate Formalities

Corporations are subject to more formalities and filing requirements than other entity structures. As such, S-Corps have all the legal and corporate hoops that owners need to jump through. This includes shareholder meetings, corporate filings, choosing officers and boards of directors, following legal requirements in the state of formation, etc.

Paying Reasonable Compensation

Active owners in an S-Corporation must pay reasonable compensation in the form of W2 wages. As noted above, this is an advantage but also a potential pitfall. Having to file payroll reports, remembering to include more than 2% shareholder health insurance paid by the company as gross income, figuring out reasonable compensation for each officer, etc. are just a few challenges of S-Corp ownership.

Avoiding the Pitfalls

Setting up and operating an S-Corporation is not as simple as filing a few documents with the government. There are several challenges to S-Corp ownership than many shareholders don’t realize. This article is just a small list of pitfalls to S-Corp ownership so please consult with a trusted tax or legal advisor to see what filing status is best for your business.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

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1 comment on “Avoid These S-Corp Pitfalls

  1. Jennifer

    Is this relevant only if the busines is structured as an S-Corp or if the business has a LLC structure but is choosing to be taxed as an S-Corp? Excellent and easy to undrstand article, very concise.

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